10.

UNIT - IV
MANAGEMENT OF RECEIVABLES

10.15 MEANING AND OBJECTIVE

Management of receivables refers to planning and controlling of 'debt' owed to the firm from
customer on account of credit sales. It is also known as trade credit management.
The basic objective of management of receivables (debtors) is to optimise the return on investment
on these assets.
When large amounts are tied up in receivables, there are chances of bad debts and there will be cost of
collection of debts. On the contrary, if the investment in receivables is low, the sales may be restricted,
since the competitors may offer more liberal terms. Therefore, management of receivables is an
important issue and requires proper policies and their implementation.

10.16 ASPECTS OF MANAGEMENT OF DEBTORS

There are basically three aspects of management of receivables:
1. Credit Policy: A balanced credit policy should be determined for effective management of
receivables. Decision of Credit standards, Credit terms and collection efforts is included in Credit
policy. It involves a trade-off between the profits on additional sales that arise due to credit
being extended on the one hand and the cost of carrying those debtors and bad debt losses on
the other. This seeks to decide credit period, cash discount and other relevant matters. The
credit period is generally stated in terms of net days. For example, if the firm’s credit terms are
“net 50”. It is expected that customers will repay credit obligations not later than 50 days.
Further, the cash discount policy of the firm specifies:
(a) The rate of cash discount.
(b) The cash discount period; and
(c) The net credit period.
 For example, the credit terms may be expressed as “3/15 net 60”. This means that a 3%
discount will be granted if the customer pays within 15 days; if he does not avail the offer he
must make payment within 60 days.
2. Credit Analysis: This requires the finance manager to determine as to how risky it is to
advance credit to a particular party. This involves due diligence or reputation check of the
customers with respect to their credit worthiness.
3. Control of Receivable: This requires finance manager to follow up debtors and decide about a
suitable credit collection policy. It involves both laying down of credit policies and execution of
such policies.
There is always cost of maintaining receivables which comprises of following costs:
(i) The company requires additional funds as resources are blocked in receivables which
involves a cost in the form of interest (loan funds) or opportunity cost (own funds)
(ii) Administrative costs which include record keeping, investigation of credit worthiness
etc.
(iii) Collection costs.
(iv) Defaulting costs.

10.17 FACTORS DETERMINING CREDIT POLICY

The credit policy is an important factor determining both the quantity and the quality of accounts
receivables. Various factors determine the size of the investment a company makes in accounts
receivables. They are, for instance:
(i) The effect of credit on the volume of sales;
(ii) Credit terms;
(iii) Cash discount;
(iv) Policies and practices of the firm for selecting credit customers;
(v) Paying practices and habits of the customers;
(vi) The firm’s policy and practice of collection; and
(vii) The degree of operating efficiency in the billing, record keeping and adjustment function, other
costs such as interest, collection costs and bad debts etc., would also have an impact on the
size of the investment in
 10.3

receivables. The rising trend in these costs would depress the size of investment in receivables.
The firm may follow a lenient or a stringent credit policy. The firm which follows a lenient credit policy
sells on credit to customers on very liberal terms and standards. On the contrary a firm following a
stringent credit policy sells on credit on a highly selective basis only to those customers who have
proper credit worthiness and who are financially sound.
Any increase in accounts receivables that is, additional extension of trade credit not only results in
higher sales but also requires additional financing to support the increased investment in accounts
receivables. The costs of credit investigations and collection efforts and the chances of bad debts
are also increased. On the contrary, a decrease in accounts receivable due to a stringent credit policy
may be as a result of reduced sales with competitors offering better credit terms.

10.18 FACTORS UNDER THE CONTROL OF THE FINANCE

MANAGER
The finance manager has operating responsibility for the management of the investment in receivables.
His involvement includes:-
(a) Supervising the administration of credit;
(b) Contribute to top management decisions relating to the best credit policies of the firm;
(c) Deciding the criteria for selection of credit applications; and
(d) Speed up the conversion of receivables into cash by aggressive collection policy.
In summary the finance manager has to strike a balance between the cost of increased
investment in receivables and profits from the higher levels of sales.

10.19 APPROACHES TO EVALUATION OF CREDIT POLICIES

There are basically two methods of evaluating the credit policies to be adopted by a Company –
Total Approach and Incremental Approach. The formats for the two approaches are given as under:
Statement showing the Evaluation of Credit Policies (based on Total Approach)
Particulars Present Proposed Proposed Proposed
Policy Policy I Policy II Policy III
` ` ` `
A. Expected Profit:
(a) Credit Sales ………. …………. ……….. ……….
(b) Total Cost other than Bad Debts

(i)Variable Costs ……… ………… ………. ……….

(ii) Fixed Costs ……… ………… ………. ……….
……… ………. ………. ……..
(c) Bad Debts ……… ………… ……… ……….
(d) Cash discount
(e) Expected Net Profit before Tax .…….. ……….. ……… ……….
(a-b-c-d)
(f) Less: Tax ……... ……….. ………. ………
(g) Expected Profit after Tax ..……. ……… ……… ………
B. Opportunity Cost of Investments in ..…… ……… ………. ………
Receivables locked up in Collection
Period

Net Benefits (A – B) ……… ……… ……… ……….

Advise: The Policy……. should be adopted since the net benefits under this policy are higher as
compared to other policies.
Here
(i) Total Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of
units sold on credit under Present Policy
(ii) Opportunity Cost = Total Cost of Credit Sales ×
Collection period (Days) Required Rate of Return 365 (or
360) × 100
 10.5

Statement showing the Evaluation of Credit Policies (based on Incremental Approach)

Particulars Present Proposed Proposed Proposed
Policy Policy I Policy II Policy III
days days days days
` ` ` `
A. Incremental Expected Profit:
Credit Sales ………. …………. ……….. ……….
(a) Incremental Credit Sales ………. …………. ……….. ……….
(b) Less: Incremental Costs of
Credit Sales
(i) Variable Costs ………. …………. ……….. ……….
(ii) Fixed Costs ………. …………. ……….. ……….
(c) Incremental Bad Debt Losses ………. …………. ……….. ……….
(d) Incremental Cash Discount ………. …………. ……….. ……….
(e) Incremental Expected Profit (a-b-c- ………. …………. ……….. ……….
d)
(f) Less: Tax ………. …………. ……….. ……….
(g) Incremental Expected Profit after ………. …………. ……….. ……….
Tax
………. …………. ……….. ……….
B. Required Return on
Incremental Investments:
(a) Cost of Credit Sales ………. …………. ……….. ……….
(b) Collection Period (in days) ………. …………. ……….. ……….
(c) Investment in Receivable (a × ………. …………. ……….. ……….
b/365 or 360)
(d) Incremental Investment in ………. …………. ……….. ……….
Receivables
(e) Required Rate of Return (in %) ………. …………. ……….. ……….
(f) Required Return on Incremental ………. …………. ……….. ……….
Investments (d × e)

Incremental Net Benefits (A – B) ………. …………. ……….. ……….

Advise: The Policy ……should be adopted since net benefits under this policy are higher as
compared to other policies.
Here:
(i) Total Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of
units sold on credit under Present Policy
(ii) Opportunity Cost = Total Cost of Credit Sales ×
Collection period (Days) Required Rate of Return 365 (or
360) × 100
 10.7

10.20 FINANCING RECEIVABLES

10.20.1 Pledging and Factoring
Pledging of accounts receivables and Factoring have emerged as the important sources of financing of
accounts receivables now-a-days.
(i) Pledging: This refers to the use of a firm’s receivable to secure a short term loan. After cash, a
firm’s receivables can be termed as its most liquid assets and this serve as prime collateral
for a secured loan. The lender scrutinizes the quality of the account receivables, selects
acceptable accounts, creates a lien on the collateral and fixes the percentage of financing
receivables which ranges around 50 to 90%. The major advantage of pledging accounts
receivables is the ease and flexibility it provides to the borrower. Moreover, financing is done
regularly. This, however, suffers on account of high cost of financing. Also being a loan, it
leaves an impact on the debt equity ratio as well by increasing the amount of debt.
(ii) Factoring: Factoring is a relatively new concept in financing of accounts receivables. This refers
to outright sale of accounts receivables to a factor or a financial agency. A factor is a firm that
acquires the receivables of other firms. The factoring lays down the conditions of the sale in a
factoring agreement. The factoring agency bears the risk of collection and services the accounts
for a fee.
 Factor

Customers send The factor pays an agreed-upon

payment to the percentage of the accounts receivable
factor to the firm.

Customer Firm
Goods
Factoring arrangement can be either on a recourse basis or on a non-recourse basis:
- Recourse: In case factor is unable to collect the amount from receivables then, factor can turn
back the same to the organization for resolution (which generally is by replacing those
receivables with new receivables)
- Non-Recourse: The factor bears the ultimate risk of loss in case of default and hence in such
cases they charge higher commission.
There are a number of financial institutions providing factoring services in India. Some commercial
banks and other financial agencies provide this service. The biggest advantages of factoring are the
immediate conversion of receivables into cash and predicted pattern of cash flows. Financing
receivables with the help of factoring can help a company having liquidity without creating a net liability
on its financial condition and hence no impact on debt equity ratio. Besides, factoring is a flexible
financial tool providing timely funds, efficient record keepings and effective management of the
collection process. This is not considered as a loan. There is no debt repayment and hence no
compromise to balance sheet, no long-term agreements or delays associated with other methods of
raising capital. Factoring allows the firm to use cash for the growth needs of business.
The basic format of evaluating factoring proposal is given as under:
Statement showing the Evaluation of Factoring Proposal
Particulars `
A. Annual Savings (Benefit) on taking Factoring Service
Cost of credit administration saved ………...
Bad debts avoided ………
…
 10.9

Interest saved due to reduction in average collection period (Wherever ………

applicable) …
[Cost of Annual Credit Sales × Rate of Interest × (Present Collection
Period – New Collection Period)/360* days]

Total ………..
B. Annual Cost of Factoring to the Firm:
Factoring Commission [Annual credit Sales × % of Commission (or ………..
calculated annually)]
Interest Charged by Factor on advance (or calculated annually ) ………...

[Amount available for advance or (Annual Credit Sales – Factoring

Commission – Factoring Reserve)] × Collection Period
[
(days)
×Rate of Interest]
360 *
Total ………..
C. Net Annual Benefits/Cost of Factoring to the Firm: A-B
Rate of Effective Cost of Factoring to the Firm
Net Annual cost of Factoring
= Amount available for advance×100 or
Net annual Cost of Factoring
Advances to be paid ×100
Advances to be paid = (Amount available for advance – Interest
deducted by factor)

*1 Year is taken as 360 days

Advise:
1. The company should avail Factoring services if rate of effective Cost of Factoring to the firm is
less than the existing cost of borrowing or if availing services of factoring results in to positive
Net Annual Benefits.
2. The company should not avail Factoring services if the Rate of Effective Cost of Factoring to
the Firm is more than the existing cost of borrowing.
10.20.2 Forfaiting
Meaning of Forfaiting
‘Forfait’ is a French term which means “relinquish a right”. Forfaiting is an arrangement of bill
discounting in which a financial institution or bank buys the trade bills (invoices) or trade receivables
from exporters of goods or services, where the exporter relinquish his right to receive payment from
importer. Financial Institutions or banks provides immediate finance to exporter ‘without recourse’
basis in which risk and rewards related with the bills/ receivables transferred to the financial institutions/
banks. It is a unique credit facility arrangement where an overseas buyer (importer) can open a "letter
of credit" (or other negotiable instruments) in favour of the exporter and can import goods and services
on deferred payment terms.
Functions of Forfaiting
The functionality can be understood in the following manner:
(i) Exporter sells goods or services to an overseas buyer.
(ii) The overseas buyers i.e. the importer on the basis trade bills and import documents draws a
letter of credit (or other negotiable instruments) through its bank (known as importer’s bank).
(iii) The exporter on receiving the letter of credit (or other negotiable instruments) approaches to
its bank (known as exporter’s bank).
(iv) The exporter’s bank buys the letter of credit (or other negotiable instruments) ‘without recourse
basis’ and provides the exporter the payment for the bill.
 10.11

Exporter sells Goods/ Services

Importer draws Letter of Credit
Importer

Exporter

3. Exporter approaches bank Exporter’s bank

4. Bank pays the Exporter

Features of Forfaiting
The Salient features of forfaiting are:
 It motivates exporters to explore new geographies as payment is assured.
 An overseas buyer (importer) can import goods and services on deferred payment terms.
 The exporter enjoys reduced transaction costs and complexities of international trade
transactions.
 The exporter gets to compete in the international market and can continue to put his working
capital to good use to scale up operations.
 While importers avail of forfaiting facility from international financial institutions in order to
finance their imports at competitive rates.
Example of Forfaiting:
Exim Bank of India’s ‘Buyer’s Credit’ is an example of forfaiting arrangement. Buyer’s Credit programme
facilitates exports for SMEs by providing credit to overseas buyer to import goods from India. It is
offering financing of capital goods or services on deferred payment terms and provides non-recourse
finance to Indian exporters by converting deferred credit contract into cash contract. It extends advance
payments to Indian exporters on behalf of the overseas buyer.
The following is a diagrammatic illustration of Exim’s Buyer’s Credit:

(Source: https://www.eximbankindia.in/buyers-credit)

10.21 INNOVATIONS IN RECEIVABLE MANAGEMENT

During the recent years, a number of tools, techniques, practices and measures have been
invented to increase effectiveness in accounts receivable management.
Following are the major determinants for significant innovations in accounts receivable management
and process efficiency.
1. Re-engineering Receivable Process: In some of the organizations real cost reductions and
performance improvements have been achieved by re- engineering in accounts receivable
process. Re-engineering is a fundamental re-think and re-design of business processes by
incorporating modern
 10.13

business approaches. The nature of accounts receivables is such that decisions made
elsewhere in the organization are likely to affect the level of resources that are expended on
the management of accounts receivables.
The following aspects provide an opportunity to improve the management of accounts
receivables:
(a) Centralisation: Centralisation of high nature transactions of accounts receivables and
payable is one of the practices for better efficiency. This focuses attention on specialized
groups for speedy recovery.
(b) Alternative Payment Strategies: Alternative payment strategies in addition to traditional
practices result into efficiencies in the management of accounts receivables. It is
observed that payment of accounts outstanding is likely to be quicker where a number of
payment alternatives are made available to customers. Besides, this convenient payment
method is a marketing tool that is of benefit in attracting and retaining customers. The
following alternative modes of payment may also be used along with traditional methods
like Cheque Book etc., for making timely payment, added customer service, reducing
remittance processing costs and improved cash flows and better debtor turnover.
(i) Direct debit: I.e., authorization for the transfer of funds from the purchaser’s bank
account.
(ii) Integrated Voice Response (IVR): This system uses human operators and a
computer-based system to allow customers to make payment over phone. This
system has proved to be beneficial in the organisations processing a large
number of payments regularly.
(iii) Collection by a third party: The payment can be collected by an authorized
external firm. The payments can be made by cash, cheque, credit card or
Electronic fund transfer. Banks may also be acting as collecting agents of their
customers and directly depositing the collections in customers’ bank accounts.
(iv) Lock Box Processing: Under this system an outsourced partner captures cheques
and invoice data and transmits the file to the client firm for processing in that firm’s
systems.
(v) Payments via Internet using fund transfer methods like RTGS, NEFT, IPMS UPIs,
App based payment like Paytm, Phone Pe, etc.
 (c) Customer Orientation: Where individual customers or a group of customers have some
strategic importance to the firm a case study approach may be followed to develop good
customer relations. A critical study of this group may lead to formation of a strategy for
prompt settlement of debt.
2. Evaluation of Risk: Risk evaluation is a major component in the establishment of an effective
control mechanism. Once risks have been properly assessed controls can be introduced to
either contain the risk to an acceptable level or to eliminate them entirely. This also provides an
opportunity for removing inefficient practices. This involves a re-think of processes and
questioning the way that tasks are performed. This also opens the way for efficiency and
effectiveness benefits in the management of accounts receivables.
3. Use of Latest Technology: Technological developments now-a-days provides an opportunity
for improvement in accounts receivables process. The major innovations available are the
integration of systems used in the management of accounts receivables, the automation and the
use of e- commerce.
(a) E-commerce refers to the use of computer and electronic telecommunication
technologies, particularly on an inter- organisational level, to support trading in goods
and services. It uses technologies such as Electronic Data Inter-change (EDI), Electronic
Mail, Electronic Funds Transfer (EFT) and Electronic Catalogue Systems to allow the
buyer and seller to transact business by exchange of information between computer
application systems such as Amazon, Flipkart etc.
(b) Automated Accounts Receivable Management Systems: Now-a- days all the big
companies develop and maintain automated receivable management systems. Manual
systems of recording the transactions and managing receivables are not only
cumbersome but ultimately costly also. These integrated systems automatically update
all the accounting records affected by a transaction. For example, if a transaction of
credit sale is to be recorded, the system increases the amount the customer owes to
the firm, reduces the inventory for the item purchased, and records the sale. This
system of a company allows the application and tracking of receivables and collections,
using the automated receivables system allows the company to store important
 10.15

information for an unlimited number of customers and transactions, and accommodate

efficient processing of customer payments and adjustments.
4. Receivable Collection Practices: The aim of debtors’ collection should be to reduce, monitor and
control the accounts receivable at the same time maintain customer goodwill. The
fundamental rule of sound receivable management should be to reduce the time lag between
the sale and collection. Any delays that lengthen this span causes receivables to unnecessary
build up and increase the risk of bad debts. This is equally true for the delays caused by
billing and collection procedures as it is for delays caused by the customer.
The following are major receivable collection procedures and practices:
(i) Issue of Invoice.
(ii) Open account or open-end credit.
(iii) Credit terms or time limits.
(iv) Periodic statements and follow ups.
(v) Use of payment incentives and penalties.
(vi) Record keeping and Continuous Audit.
(vii) Export Factoring: Factors provide comprehensive credit management, loss protection
collection services and provision of working capital to the firms exporting
internationally.
(viii) Business Process Outsourcing: This refers to a strategic business tool whereby an
outside agency takes over the entire responsibility for managing a business process like
collections in this case.
5. Use of Financial tools/techniques: The finance manager while managing accounts receivables
uses a number of financial tools and techniques. Some of them have been described hereby
as follows:
(i) Credit analysis: While determining the credit terms, the firm has to evaluate individual
customers in respect of their credit worthiness and the possibility of bad debts. For this
purpose, the firm has to ascertain credit rating of prospective customers.
Credit rating: An important task for the finance manager is to rate the various debtors
who seek credit facility. This involves decisions
 regarding individual parties so as to ascertain how much credit can be extended and for
how long. In foreign countries specialized agencies are engaged in the task of
providing rating information regarding individual parties. Dun and Broad street is one
such source.
The finance manager has to look into the credit-worthiness of a party and sanction credit
limit only after he is convinced that the party is sound. This would involve an analysis of
the financial status of the party, its reputation and previous record of meeting
commitments.
The credit manager here has to employ a number of sources to obtain credit information.
The following are the important sources:
Trade references; Bank references; Credit bureau reports; Past experience; Published
financial statements; and Salesman’s interview and reports.
Once the credit-worthiness of a client is ascertained, the next question is to set a limit
of the credit. This credit limit once set can be further enhanced as the favorable
experience is gained while dealing with that client. In all such enquiries, the credit
manager must be discreet and should always have the interest of high sales in view at
the same time balancing any risk of non-collection.
(ii) Decision tree analysis of granting credit: The decision whether to grant credit or not is a
decision involving costs and benefits. When a customer pays, the seller makes profit but
when he fails to pay the amount of cost going into the product is also gone. If the relative
chances of recovering the dues can be decided, it can form a probability distribution of
payment or non-payment. If the chances of recovery are 9 out of 10 then probability of
recovery is 0.9 and that of default is 0.1.
Credit evaluation of a customer shows that the probability of recovery is 0.9 and that
of default is 0.1, the revenue from the order is ` 5 lakhs and cost is ` 4 lakhs. The
decision is whether credit should be granted or not.
 10.17

The analysis is presented in the following diagram.

Pays Probability (0.9) ₹1,00,000

Grant
Credit Does not Pay
Evaluation Probability (0.1) ₹4,00,000
Do not Grant

The weighted net benefit is ` [1,00,000 × 0.9 i.e. 90,000 – 0.1 × 4,00,000 i.e. 40,000] = 50,000.
So, credit should be granted.
(iii) Control of receivables: Another aspect of management of debtors is the control of receivables.
Merely setting of standards and framing a credit policy is not sufficient; it is, equally important to
control receivables by constant monitoring and follow ups.
(iv) Collection policy: Efficient and timely collection of debtors ensures that the bad debt losses are
reduced to the minimum and the average collection period is shorter. If a firm spends more
resources on collection of debts, it is likely to have smaller bad debts. Thus, a firm must work out
the optimum amount that it should spend on collection of debtors. This involves a trade- off
between the level of expenditure on the one hand and decrease in bad debt losses and
investment in debtors on the other.
The collection cell of a firm has to work in a manner that it does not create too much
resentment amongst the customers. On the other hand, it has to keep the amount of the
outstanding in check. Hence, it has to work in a very smoothen manner and diplomatically.
It is important that clear-cut procedures regarding credit collection are set up. Such
procedures must answer questions like the following:
(a) How long should a debtor balance be allowed to exist before collection process is
started?
(b) What should be the procedure of follow up with defaulting customer? How reminders are
to be sent and how should and at what frequency, each successive reminder be drafted?
(c) Should there be collection machinery whereby personal calls by company’s
representatives are made?
 (d) What should be the procedure for dealing with doubtful accounts? Is legal action to be
instituted or some escalation matrix to be followed ? How should account be handled?

10.22 MONITORING OF RECEIVABLES

Constant monitoring of the current status of receivables is very essential for any
organization to make sure that its receivables management is as effective as it should be.
Various steps that constitute constant monitoring are:
(i) Computation of average age of receivables: It involves computation of average collection period.
(ii) Ageing Schedule: When receivables are analysed according to their age, the process is known
as preparing the ageing schedules of receivables. The computation of average age of
receivables is a quick and effective method of comparing the liquidity of receivables with the
liquidity of receivables in the past and also comparing liquidity of one firm with the liquidity of the
other competitive firm. It also helps the firm to predict collection pattern of receivables in future.
This comparison can be made periodically.
The purpose of classifying receivables by age groups is to have a closer control over the quality
of individual accounts. It requires going back to the receivables’ ledger where the dates of each
customer’s purchases and payments are available. The ageing schedule, by indicating a
tendency for old accounts to accumulate, provides a useful supplement to average collection
period of receivables/sales analysis. Because an analysis of receivables in terms of associated
dates of sales enables the firm to recognise the recent increases, and slumps in sales. To
ascertain the condition of receivables for control purposes, it may be considered desirable to
compare the current ageing schedule with an earlier ageing schedule in the same firm and also
to compare this information with the experience of other firms. The following is an illustration of
the ageing schedule of receivables:-
Ageing Schedule
10.19